In today’s economy, a credit card is an important financial tool that is often necessary to build credit, set up accounts and make certain purchases. In the United States, approximately 174 million adults have at least one credit card – yet many do not understand how do credit cards work. Knowing the fundamentals of how credit cards work can help you use them wisely.
What is a Credit Card?
The first step to answering the question, how do credit cards work, is understanding what a credit card is. A credit card is essentially an account that permits you to borrow money from a bank or credit union to make purchases. If you pay back that money within a set period of time, typically 25 to 30 days, then the money is paid back and that is that. Credit cards come with interest rates which are charged on outstanding balances. So if you do not pay back the full amount, then you will owe the bank interest on top of what you borrowed.
Credit cards can be used to purchase almost anything, from a coffee at Starbucks to a lavish vacation. The rules for paying back the money you borrowed by swiping your card or inputting your credit card number are the same: if you do not pay the money back in full, then you will be required to pay interest in addition to what you borrowed when you made the purchase. Credit cards are important credit building tools for consumers, and they offer rewards and benefits for spending.
What is a Credit Card Balance?
The second step behind how do credit cards work is the credit card balance. A credit card balance is the amount of money you owe to your credit card company, otherwise known as debt. It can consist of purchases made on your credit card, interest charges, and any fees that you may have been charged such as a late fee. Each purchase you make will increase your credit card balance, while each payment you make will decrease your balance.
If you do not pay off your credit card balance in full each month, your balance will carry forward to the following month with interest being added to it. In general, paying off your entire balance each month is recommended if you want to avoid interest charges adding to your balance.
How Do Credit Card Interest Rates Work?
When you signed up for a credit card, you may have briefly noted the annual percentage rate, or APR, charged for interest. While this number may seem relatively straightforward, the way credit cards charge interest is actually quite complex. Failing to understand how credit card interest rates work can lead to you racking up quite a substantial amount of debt in interest charges.
While credit card companies advertise their interest rates in terms of APR, interest on unpaid balances is calculated on a daily basis. Every day you carry an unpaid balance on your credit card, you will be charged interest — and that interest will be compounded, which means it will be added to your balance, and the next day, you’ll be paying interest on a slightly larger balance. This makes it more difficult to pay off your credit card balances. However, keep in mind that APR is an annual rate, so when it is calculated on a daily basis, the rate is divided by 360 or 365 depending on who is charging interest.
You can determine how much interest you will actually be charged by looking at your credit card statement. It will list your Daily Periodic Rate (DPR), which is your APR divided by the number of days in the year used by your credit card issuer. For example, if your APR was 15 percent and your card issuer uses a 365-day year, then your DPR is 0.00041 percent.
Next, find your average daily balance that is subject to interest; this is the amount that is unpaid from the previous month. This number should also be listed on your account statement. Finally, multiply your DPR times your average daily balance and the number of days in your billing cycle. If you had a $1,000 balance from the previous month, a 30-day billing cycle and a DPR of .00041 percent, then you will pay an interest charge of $12.30 for that month. This amount will be added to your balance, so even if you do not make a single purchase on your credit card, your balance will continue to grow if you are not making payments.
What is a Minimum Payment?
For credit cards, a minimum payment is the lowest amount you can pay each month without incurring late fees. Typically, a minimum payment is calculated as a percentage of your total current balance (between 1 percent and 3 percent), or the minimum payment plus 1 percent to 3 percent of the principal amount due. If your credit card balance is $500, a minimum payment of 1 percent could be as little as $5. The next month, if you have the same balance of $500, but also have a late fee of $35, plus interest charges of $7, then your minimum payment of 1 percent plus fees and interest would be $47.
The minimum payment is the lowest amount you can pay and not have it negatively impact your credit score as a late payment penalty. For example, if you owe $1,000 on your credit card, you may have a minimum payment of $50. As long as you pay $50 by the bill’s due date, then you will not get a late fee or be reported to the credit bureaus as being overdue.
What Are Common Credit Card Fees?
When understanding how do credit cards work, there may be nothing as important as the fees surrounding the card. If you decide to get a credit card, you should be aware that many credit cards charge fees — but that many of these fees can be avoided by choosing carefully and planning ahead. While some fees are for the perks of the credit card itself, the majority are based on the way you use a credit card.
Annual fees are common for credit cards that offer bonuses such as travel miles, hotel stays, cash back and other bonuses. They can be relatively low, or as high as $500 a year or more. If you have a well-established credit score and can afford it, a credit card with an annual fee may be worth it, particularly if the perks of the card (like free travel) outweigh the cost. Just be sure to read the fine print to make sure you understand the rules of the card before signing up for it.
If you use your credit card to get cash, you will be charged a fairly significant cash advance fee for doing so — as much as 5 percent of the total amount of the advance. This is often on top of whatever ATM fees you took out, and in addition to the interest you will be charged. The best way to avoid these fees is to never use your credit cards as a source of cash.
Late fees are charged when you do not make your payment on time, and are usually anywhere from $25 to $35. This amount will be added to your balance, and will also negatively impact your credit score. The only way to avoid getting late fees is to always make sure to pay your credit card bills on time. If you missed your payment by accident, you may be able to have this fee waived if it was an unusual occurrence. A related fee is an expedited payment fee of $10 to $15 for making a payment over the phone to avoid a late payment fee — which is pricey, but less expensive than a late payment fee.
Balance transfer fees are another common type of credit card fee, which are assessed whenever you move a balance from one credit card to another. Generally, the fee is a certain percentage of the amount transferred, such as 3 percent, which can be a substantial amount. However, if you are transferring your balance to take advantage of a credit card with a zero percent introductory interest rate, it may be worth it to pay this fee.
What Are the Different Types of Credit Cards?
The final step in learning how do credit cards work is realizing how many different types of credit cards there are. When choosing a credit card, it helps to know what your options are so you can make the best choice for your financial situation and goals.
Secured Credit Cards
A secured credit card is a good option for anyone without a credit history or with a damaged credit history. A secured credit card is backed by a cash deposit, and the credit limit is typically the same as the deposit amount. The card can be then used like any other card. If you don’t make your payments, the cash deposit acts as collateral. Once you close the account, the deposit will be returned. This type of card can help you establish or rebuild a credit history in order to qualify for a traditional credit card.
Travel Credit Cards
Travel credit cards can be rewarding for frequent travelers, as they give you the ability to earn free flights, hotel stays, rental cars and other perks, such as airline upgrades. The way they work is simple: you choose a credit card based on the type of travel you do or plan to, such as a card that is linked with your preferred airline. Look for a card that offers bonus miles or other rewards. Then when you make purchases on your card, you will receive points or miles that can be redeemed for flights, hotel stays, or other rewards. These credit cards often have an annual fee.
Cash Back and Rewards Credit Cards
If you would rather get cash back or other rewards for your credit card purchases, consider a credit card that offers these perks. Like travel credit cards, rewards credit cards allow users to earn either money or points for making purchases. The points can usually be used towards buying items with partner merchants, and the cash may be sent in the form of a check or given as a credit to your account. As with travel credit cards, cash back and rewards cards may have an annual fee.
Balance Transfer Credit Cards
For anyone carrying a balance on their credit card, balance transfer credit cards may be an attractive way to pay off that debt. These cards offer low or even zero percent interest rate promotional fees for a period of time. This allows you to apply for the card, transfer your balance, and ideally pay off your credit card balance before the promotional period has expired. Just be aware that there is typically a balance transfer fee associated with these cards, and if you don’t pay off the balance before the promotional period is up, you will be paying interest on the remaining balance.